Inflation forecast: Enough of RBI’s Elevator Economics, says Surjit Bhalla

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New Delhi | Published: April 29, 2017 5:04:16 AM

The Indian economy has likely gone through a mega structural break experience via demonetisation.


The Indian economy has likely gone through a mega structural break experience via demonetisation. A major institution in India, RBI, was, by definition, right in the thick of this entire experiment. Unfortunately, too much ink has been spilled on the decision of whether it was appropriate for the economic RBI to agree to the political demonetisation decision. My own personal view is that while RBI was the technical authority to agree to the demonetisation decision, it wasn’t under its mandate, or authority, to not agree to the political demonetisation decision.

What is clear is that RBI faltered, and faltered badly, in the implementation of the decision. Its reputation has taken a beating, and it is unfortunate that all the blame for the faulty implementation has been foisted onto the new Governor, Urjit Patel. This is worse than baptism by fire, but is very much part of the prestigious, and powerful, job as head one of the major institutions in India, RBI.

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In September 2016, a new institution was created within the RBI—the Monetary Policy Committee (MPC), a six-member committee to decide on monetary policy. It is the functioning of this new 8-month-old institution that I want to discuss. The MPC members are presumed to be the best and brightest in India on the subject of monetary policy. What does the performance to date reveal?
Very early on, an important part of a child’s education is the learning of the three Rs—reading, (w)riting and (a)rithmetic.

Analogously, a critical part of a central banker’s education is to follow the 3Cs—Clarity in thought, (logical) Consistency, and effective Communication. If the three Cs are kept in mind, the central banker (or MPC member) achieves the ultimate goal—Credibility. Communication: This is the easiest of the three Cs, yet an area where the MPC has performed badly. Very early on, reporters of major news agencies (BBC, Economist, Firstpost) were shut-out, Trump-like, from press conferences. Was this done because they would not be docile-like and feed lollipop questions to RBI brass at the policy press-conferences? The new RBI has also stopped publishing transcripts of post-Policy discussions with investors. Why? By any definition this qualifies as poor communication—and with precious little justification.

It gets worse. MPC members are prohibited (again, the favourite Indian policymaker policy—when in doubt, ban) from talking to experts, journalists, etc, about their thinking, and/or their justification, on the policy decisions they have made and published in the minutes of the MPC meeting. It is perfectly understandable (indeed, required) that leading up to the policy decision, there be a quiet period. But, post the decision?

The reason all of this is very relevant is because the MPC makes some important decisions affecting the lives of all Indians—their judgement, and particularly their judgement on past and future inflation, affects their decision on interest rates, and this decision affects all aspects of our economy. Indeed, for most countries, developing and developed, the interest rate decision is the most important economic decision made by any part of the government, including the ministry of finance. And we are being told that this decision is now being made by the SSS (super secret society?), However, what compounds the error of secrecy is that it appears that the new RBI decisions are not supported by data on inflation.

The inflation forecast is the most important aspect of the most important economic decision. How has the new RBI performed on this parameter?
Extraordinarily poorly. In December 2016, the MPC made the bold forecast that headline inflation in India would average 5% in January-March 2017, and that there was an upside bias! This forecast was post-demonetisation and the minutes of the meeting do indicate that RBI was well aware of the possibility that headline inflation would fall. Yet, they persisted with their forecast—one that the docile bureaucratic babu-pink press did not much question.

The actual inflation during January-March turned out to be 3.6%, a full 1.4 percentage points below the three-month forward forecast. This (absolute) error is double the average error over the previous three years (2014 to 2016). In percentage error terms (in this instance, the error is 39 %) this error is larger than any other in RBI history. In the three prior years (2014-2016), the error averaged 0.7 percentage points, or an average 12 % error. In other words, the MPC error in 2017 (i.e., the easiest forecast because of demonetisation) was more than three times the average error over the last three years.

Some of us had explicitly stated that actual inflation January-March 2017 would be nowhere close to the judgement of the expert MPC. Why are these errors so large? Perusing through the MPC documents (and similar ones in other countries) it does appear that the errors are common because our own RBI indulges in what can only be called Elevator Economics—the entire “analysis” is composed of statements that this went up, and that went down. Period. There is no attempt at analysing or explaining why.

What is discouragingly amusing is that the MPC does not even get its analysis of the past right! In an earlier article (, I had mentioned about the faulty data used by RBI on core inflation—a critical variable for policy. What the nation should know is that the entire 51-page semi-annual Monetary Policy Report (MPR) of RBI does not mention the word “core” with reference to Indian inflation even once! But, true to its commitment to Elevator Economics, the MPR discusses the pattern of every conceivable measure of inflation (food, vegetables, fruit, pulses, perishables, excluding food and fuel, etc)—except core.

The reason it does not mention or estimate core (defined as CPI minus food minus fuel and minus petrol) is because the conclusion goes against the MPC mantra that “inflation excluding food and fuel” has been sticky at 5%. But nowhere does RBI mention the fact that this stickiness is only there if petrol prices (contained not in fuel in the Indian CPI but in “transport and communications”) are not excluded from the calculation of core.

True core inflation rate has been declining, i.e., has not been stable. Indeed, there has been a systematic decline in the true core rate to now the lowest level (4.3%) in the last nine years (since June 2008). In October 2016, the month before demonetisation, true core inflation in India was 4.9%; a year ago (March 2016) true core inflation was 5.1%.

Many analysts have called RBI’s bluff on “core inflation”. This maybe one reason why the MPC has now turned to discussion of the following (changing of goalposts in the game of Elevator Economics!). In the latest MPC minutes, Governor Patel concludes (along with MPC members Patra, Ghate and Dua) that “CPI inflation excluding food and fuel remained sticky, especially services.”

Let us see how the RBI performs with respect to documentation of past inflation data—a simpler exercise than a forecast. Very poorly, but you be the judge. The accompanying table documents the weight and CPI inflation, for the six most important categories of service inflation. Data are presented for three months: March 2017, a year ago (March 2016), and the month prior to demonetisation, October 2016. The six categories are combined, in a weighted fashion, to yield a composite service inflation with a weight of 34.3% in the total CPI.

Far from being sticky, each component of service inflation shows a large y-o-y decline, ranging between 130 basis points (health) and 30 basis points (housing). The weighted average decline is 80 basis points! Further, the level of service inflation in March 2017 (4.1%) is within kissing distance of the 4% target of headline inflation of the MPC!

But there is some really good news about the MPC—dissent has finally reached its shores! Professor Ravindra Dholakia openly disagrees with the other MPC members on the trend in future inflation. Dissent is very difficult in the Indian bureaucracy—the fact that it has happened means MPC’s future policy decisions will be considerably more balanced and informed.

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